I think the bootloader uses the SD card as temporary storage (maybe for uncompression or backup) during firmware update, so it's a good idea to use an empty SD card. My 256MB SD cards seem to work well when empty, and the documentation says that you must use a card larger than 128MB, so from this I deduce that it needs about 150-200MB as temporary storage (the firmware image is 55MB).

Well I only have less than 80 meg free on my 256M card and have successfully used it for a firmware upgrade. The current contents includes the firmware as I haven't bothered to remove it.